People looking to franchise their business should start the process by building a realistic financial model. This article provides a model for franchising a business with an emphasis on the importance of using a realistic and conservative financial model.
Every day until former business owners consider franchising their business. Franchise benefits can be rewarding for business owners seeking growth and increased profitability. However, there is an important caveat: the business must have the attributes to operate successfully as a franchise. There are important issues to consider when considering franchising. Here are some of the most important:
The size of the market for the product or service.
Quality of operation of the company.
Ease of running the business.
Ability to package or “cookie-cutter” for a franchise operation
Insight into business management.
competitive climate
Projected franchise investment
Amount of owners’ capital available to invest in franchising the business
The projected profitability and ROI for a franchise operation
The last item on this list is where your in-depth franchise analysis should begin. This is not to say that the above questions are not important, because they are. Rather, a franchise’s ability to be financially successful is the critical piece of the equation, and the one that potential franchisors often overlook. It is instinctive for the business owner to focus on the product, sales and operations.
The Financial Model
Step 1
The first step in the process is to build a pro forma financial statement for a franchise operation.
You must build the proforma based on the financial results of one of your actual locations. Use a spreadsheet format to view various financial models. If you don’t know how to use a spreadsheet program, find a friend or family member who can help you. The advantage of using a spreadsheet is that you can change the inputs to display multiple results. Known as sensitivity analysis, multiple pro formas allow you to represent different financial scenarios.
Adjust finances for the following:
1. Eliminate any unusual expenses that a franchisee would not have to incur.
2. Include the salaries of employees who dedicate their efforts to the operation of the franchise and not to other business activities, such as bookkeeper or owner.
3. If there is more than one business location and collective expenses are recorded at one location, you should use an average of these expenses for your pro forma. An example would be advertising or supplies.
4. Make sure the sales figure is realistic. There is little point in using a sales figure for a location that has been open for several years, since a franchise must start from scratch. Adjusted to reflect sales from a first year operation. Don’t expect a franchisee to achieve the same level of sales as the current business.
5. Add owner’s income, amortization, depreciation, interest, owner’s benefits, and non-earning wages to pre-tax income.
6. Make sure the gross margin percentage is realistic. If you are going to adjust err on the conservative side.
7. Calculate income before taxes.
8. Use 7%-10% of sales as an estimate for royalties and ad fund fees. Deduct this amount from your pre-tax income.
The result should be an estimated income for a franchise operation.
Step 2
Estimate the investment required to start up a new location. You will need to include the costs of starting the business and marketing the products or sales. Includes six months of working capital.
The pre-tax income of the franchise must be between a minimum of 30% and a maximum of 50% of the total investment. This would reflect an ROI of 15-20% and additional income for the franchisee’s time and effort in managing the new franchise location. If your proforma has these results, it has passed a critical test in the process. On the other hand, if your results fall short of these benchmarks but are close, consider how higher sales and/or lower expenses can be achieved to increase profits.
Building a financial model for a proposed franchise operation is a critical step in the process of franchising an existing business. If the financial model is realistic and based on reasonable expectations, then you are ready to proceed to a more detailed analysis of the market, the operation and the competition.
